Prior to the mortgage meltdown of 2008, mortgage prepayment penalties were common.
These were penalties that borrowers had to pay if they paid off all or a portion of their mortgages.
Lenders imposed the penalties b/c they wanted to be able to recoup the cost of the loan before the borrower refinanced or paid it off.
For example, a lender providing a $500,000 loan could easily incur $15,000 to $20,000 of costs to fund a loan by paying the loan officer a commission of 1.5% (of the loan amount) and the borrower a 1.5% credit for closing costs.
A prepayment penalty allowed the lender to collect enough interest to recoup those costs before the borrower refinanced.
A typical prepayment penalty was six months of interest against 80% of the remaining principal. In the case of the $500,000 loan above and an interest rate of 8% (often seen at that time), the prepayment penalty would be around $16,000.
This is why prepayment penalties had to be regulated.
SLIMY MORTGAGE BROKERS & SUBPRIME LOANS
Prior to 2008, subprime and “Alt A” loans comprised a major portion of all mortgages. Some of these loans were very competitive, particularly when honest loan officers originated them.
But – slime-balls prevailed. Most of the subprime and Alt A loans were adjustable rate loans with fixed and very low “start rates” (often below 2%) that remained fixed for six months to 2 years.
Even though the start rates were fixed, the loans had adjustable rates tied to an index (like LIBOR) with a “margin” on top of the index. Hence, if LIBOR was 5%, and the margin was 3.5%, the borrower’s adjustable rate would be 8.5%.
Many slimy brokers sold the “start rate” as if it was the actual interest rate without fully explaining how the adjustable rate portion worked.
WORSE – if they saddled the borrower with a higher margin, the broker would get a higher commission.
Many mortgage brokers would sell Negative Amortization ARMs with start rates of 1.95%, sky-high margins, 3% commissions to the broker himself, and 5-year prepayment penalties.
And borrowers often had no idea what they were getting, particularly if English was a second language.
We used to frequently have borrowers come to us with sky-high rates and huge prepayment penalties, and then face the choice of either paying a $20,000 penalty or keeping the high rate (all b/c a slimy broker wanted to make an extra $7,500 of commission).
It was often heartbreaking to see this.
I rarely come out in favor of more regulation, but in this case it was necessary for obvious reasons.
Dodd-Frank, the CFPB, and the current legal environment made prepayment penalties much more difficult to impose and/or enforce, and they are virtually non-existent today with “A paper” or “QM” loans.
At JVM, we do not offer a single loan with a prepayment penalty.
Jay Voorhees at (925) 855-4491 Real Estate Broker, CA Department of Real Estate, DRE# 01524255, NMLS# 335646
